FAIR USE NOTICE. This document contains copyrighted material whose use has not been specifically authorized by the copyright owner. The Managerial Economics course is making this material available as part of our mission to promote critical thinking about economic issues. We believe that this constitutes a `fair use' of the copyrighted material as provided for in section 107 of the US Copyright Law. If you wish to use this copyrighted material for purposes of your own that go beyond `fair use', you must obtain permission from the copyright owner.

August 25, 1999
Wall Street Journal

Oh, Horrors! A Beverage-Can Oligopoly

By HOLMAN W. JENKINS JR.

Industries like aluminum used to think of the themselves as big and important. But for the rest
of us, the money we spend on one acupuncture session, hair weave or bottle of wine easily
outweighs an entire year's per capita consumption of aluminum.

Yet while the makers of "The Blair Witch Project" can earn a 100,000% return, let a
commodity business seek to escape from the profitless norm and whole bureaucracies leap into
action.

In the case of this month's convulsive aluminum mergers, looking the other way would be
the better part of wisdom. At 75 cents a pound, the industry's average cost of production has
been consistently higher than the world aluminum price for most of the past decade. A change
of plan was overdue.

The industry's five biggest players will go into a compactor, and out will come two giants,
each with about 15% of global smelting capacity. Holding up the French-speaking end will be a
combination of Alcan of Montreal, France's Pechiney and Algroup of Switzerland. Holding up
the English-speaking end will be Alcoa and Reynolds Aluminum.

At the Justice Department this will probably be seen as a resurrection of the aluminum trust.
But in a world where aluminum has become a small fish in a big pond, concentration isn't so
important anymore. Free-for-all competition like you see in the Chicago commodity pits is no
longer the discipline that big-fish customers care about.

The key discipline is the cost of capital. GM and Boeing are two customers that have lately
demonstrated this principle by signing long-term agreements (13 years and 10 years,
respectively) with their aluminum suppliers. They understand, in effect, that the customer
ultimately provides the industry's capital.

They also understand that boom and bust (the traditional way of organizing a commodity
business) is not an efficient use of capital. Both need to plan their costs out years in advance.
As GM put it, "We're trying to get away from market-driven prices."

What about smaller customers? Would a more concentrated industry mean higher prices for
them? Well, who pays the higher airline fare, your granny or a corporate executive on a
business trip? Business may fume, but it makes sense to offer discounts to marginal customers
like granny because they help defray the system's fixed costs.

Even though this is well understood, big customers still enjoy the idea of an aluminum
industry on its knees. GM raised a fuss with the trustbusters last year when Alcoa took over
Alumax, then the world's fifth-biggest aluminum maker. Washington felt obliged to show it
was on the job and forced Alcoa to sell a casting plant.

As regulators sniff the wind over whether to approve the current mergers, they can expect
complaints from an even less sympathetic set of customers, the beverage companies. Their big
cost is marketing. They don't have the planning headaches that makers of airplanes and cars
do, and have treated the aluminum industry the way granny does the airlines. Until a few
years ago, they almost never paid the full cost of production.

"It wasn't a business. It was a charity," complained Alcoa's Paul O'Neill, as he set about
fixing things. With Alcan, the second-biggest supplier of can sheet, Alcoa introduced a pricing
formula based on the cost of raw aluminum and the cost of turning it into sheet. The soda
makers whined, but the formula has largely stuck. As a sop, however, Justice did shoot down
Alcoa's plan to buy a Reynolds sheet mill, which makes an unhappy precedent for its plan now
to buy the whole company.

One of the eternal sorrows of a commodity maker is having to take this guff from companies
that can use marketing gimmickry involving rock stars and athletes to inflate their margins. In
fact Coke and Pepsi have plenty of competitive options, including stiffing the aluminum
makers altogether.

The steel industry has been pushing its technology and hoping to win back the beverage-can
business, which it thoroughly lost here in the 1970s. Steel already holds down 50% in Europe,
up from 35% a few years ago. Meanwhile, aluminum has failed to make a major dent in the
food can business. Aluminum works in pop cans only because the carbonation helps maintain
the can's otherwise flimsy structure. And everywhere aluminum makers look, they see the
PET threat--polyethylene terephthalate, the stuff of plastic bottles.

Not that the aluminum moguls wouldn't like to raise prices by taking some of the excess
smelting capacity out of the market. But, from an antitrust standpoint, Justice already got a little
pregnant when it presided over a 1994 deal to mothball high-cost plants in several countries.
Alcoa alone is sitting on 450,000 tons a year of idle capacity. The impact on prices has been
nil.
Even as its customers and markets have gone global, the industry has remained lamentably
local. You can ship aluminum anywhere in the world for a rate that usually falls with the daily
price variation of aluminum on the London Mercantile Exchange.

Yet because electricity accounts for one-third the cost of production, every time some politician
offers cheap power, the industry is tempted to build another expensive new smelter despite a
decade-long glut of the metal. British Columbia has lately been trying to lure consumers for a
big new hydropower project, even though the electricity could profitably be exported to the
U.S. Local pols want local jobs.

Huge new smelters are going up in the Mideast to make use of natural gas, and in southern
Africa to exploit hydro resources. Then there is the vast Russian smelting industry, whose
aluminum output is no longer absorbed by the decrepit Russian military machine. The
hydropower of Siberia isn't exportable to anywhere, so the smelters keep running.

We aren't innocent in this regard either. Labor unions employ their clout with the Clinton
administration to make sure cheap Bonneville power goes to aluminum smelters rather than to
consumers or sunrise industries. Until we have a truly deregulated and integrated electricity
market, the incentive to produce more aluminum than the world can swallow will remain
strong. Alcoa's outgoing chief, Mr. O'Neill, warns that the industry had better learn to live
with 30-cent aluminum--barely half today's price--by the middle of next decade.

Will any of these ideas penetrate the impermeable brain helmets that seem to be worn in
antitrust offices on both sides of the Atlantic? Probably not, but the industry has staged this
merger war wisely. By stirring up a little Yankeephobia on one side and Francophobia on the
other, both deals should fly.